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Outlook 2015: Emerging markets debt (relative)

Although the asset management industry treats emerging markets as a single entity, those countries that comprise the grouping continue to move in different directions, a trend that is almost sure to define 2015.

19/11/2014

James Barrineau

Head of Emerging Markets Debt Relative

The main drivers of this development—lower commodity prices, divergent monetary policy from major central banks, and differing responses to their regional impacts—show no signs of abating.

Those countries that comprise the emerging market grouping continue to move in different directions, a trend that is almost sure to define 2015.

Growing divergence to continue

The universe is almost evenly split between countries with positive and negative trends in the terms of trade, current account deficits of more than 3%, and real exchange rates above or below their ten-year averages. So, lower commodity prices will benefit primarily emerging Asia, and hit the rest of the asset class. Even countries normally viewed as being pillars of policy rectitude like Colombia are facing growing current account deficits amidst declining terms of trade. More directly-affected oil producers like Nigeria, Venezuela and Russia will be under increasing pressure should oil prices stabilise in a low $80 dollar price range. An extended period of triple-digit oil prices led to a ratcheting up of spending that is now under pressure. On the other hand, some countries like Chile and Indonesia which are commonly viewed as major commodity exporters, are actually feeling the benefits of lower oil prices that more than offset the hit from lower prices in commodities which they primarily export.

Currency depreciation likely

European emerging markets directly linked to the euro like Poland, Hungary, and Romania will likely endure an extended period of currency depreciation as the European Central Bank continues its campaign to soften the euro. Asian countries may decide that they need to follow suit, given the sharp depreciation in the yen. In Latin America, lower commodities and the stronger dollar will continue to drive currency depreciation there. In 2014 many emerging market central banks were able to lower interest rates in response to softer global growth. However, the pressure of lower currency levels will curtail that ability, and should that intensify, central banks may be forced to respond with higher rates even with lower growth prospects.

Grounds for optimism

All is not gloomy, however. A big slate of elections in 2014 have given Indonesia and India reform-minded leaders who could turn sentiment more positive if political systems can be bent to their agenda. Even in Brazil, the return of a disappointing incumbent may lead to reforms simply on the back of sheer necessity, as poor fiscal policy led to a complete reliance on monetary policy that has only exacerbated recessionary growth prospects. Argentina will almost certainly see a more market-friendly leader in elections in late 2015.Despite its problems, emerging market debt could still produce satisfactory returns when looked at relative to the global fixed income universe. Most of emerging market debt is investment grade and is trading at average spreads relative to US Treasuries. Yet, in a world where German ten-year bunds yield below 1%, European high yield is at about 4%, and US high yield is at about 5% (with a large component at risk in energy issuers), the yields on emerging market debt look attractive.

Non-investment grade dollar bonds are likely to struggle, however. The sovereign universe here is stressed oil producers like Venezuela and Nigeria which are likely to be forced to adjust currency regimes and fiscal policies or face potential crises. Corporate non-investment grade is also heavily exposed to commodities. Corporate issuers with dollar liabilities and local currency revenues are likely to face continued pressure. Local currency investing will continue to be out of favour as the strong dollar story steams along. However, relative to history, currencies are inexpensive and local rates are very attractive relative to developed markets. There will certainly come a time when this combination attracts investors, but this likely requires stabilisation in commodities and more clarity on developed market monetary policy endgames.

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